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Revenue recognition

Date recorded:

Identifying separate performance obligations

The Boards considered improvements and clarifications to the proposed requirements for identifying separate performance obligations included in the 2011 Revenue Exposure Draft.

The staff noted that while the 2011 Revenue Exposure Draft did not ask a question about the proposals for identifying separate performance obligations, many respondents acknowledged the improvements but requested further clarification or additional guidance and illustrative examples to assist constituents in applying the separation criterion.

The staff recommended that the Boards:

  1. Clarify the underlying principle of identifying separate performance obligations;
  2. Retain and improve the distinct concept by clarifying and refining the Boards’ intent in paragraphs 28 and 29 of the 2011 Revenue Exposure Draft by indicating that an entity should account for a promised good or service as a separate performance obligation if it would depict the substance of the contract with the customer and achieves two criteria:
    1. Capable of being distinct (principle included in paragraph 28(b)), and
      1. A few IASB Board members expressed concern with the wording and asked the staff to consider drafting changes to better capture the principle.
    2. Distinct in the context of the contract (specify the Boards’ intent of paragraph 29)
      1. An IASB Board member questioned whether it was necessary to state this as this would have been implied. The staff clarified that due to respondents feedback, it seemed that some constituents assumed a hypothetical assessment and the staff wanted the Boards to clarify that distinctiveness should be looked at in the context of the contract. An IASB Board member questioned whether being distinct in the context of the contract would triumph being capable of being distinct. The staff also clarified that while items may be capable of being individually distinct (e.g., building materials, labour etc), it could lose its distinctiveness in the context of the contract (e.g., provide a building) and therefore the second criteria would override the first criteria.
      2. Several FASB and IASB Board members expressed concern with the terminology ‘substance of the contract’ noting that some constituents would interpret this to mean that substance should override the two distinct criteria.  The staff and the Boards confirmed that this was not their intention and suggested draft changes.
  3. Clarify the Boards’ intent of paragraph 29 and improve application by including indicators to assist in determining when an entity would assess that a performance obligation would be distinct in the context of the contract.

Both Boards tentatively agreed with the staff’s recommendations above, subject to drafting changes.

Pattern of transfer

The staff noted that many respondents highlighted difficulty understanding the phrase “same pattern of transfer” and whether or not the practical expedient could be applied to consecutively transferred goods or services as well as concurrently transferred goods or services.  The staff commented that while respondents generally understood the practical expedient when applied to concurrently delivered distinct goods or services, the respondents were unclear as to whether the Boards intended for the practical expedient in paragraph 30 to apply to contracts to deliver repetitive services (e.g., cleaning service) or homogenous goods (e.g., energy) delivered consecutively.

The staff noted that it had been difficult to resolve the respondents concerns because there  appeared to be three types of arrangements that could have the same pattern of transfer:

  • a) Concurrent delivery of two or more distinct and related goods or services (i.e., two or more different but related goods or services are provided on a single day).
  • b) Concurrent delivery of two or more distinct and unrelated goods or services (i.e., two or more different and unrelated goods or services are provided on a single day).
  • c) Consecutive, or continuous, delivery of similar goods or services (i.e., good or service was provided first on Day 1, then again on Day 2, and so on).

For arrangements under (a) and (b), the staff recommended that the standard should not explicitly specify a practical expedient for concurrently delivered distinct goods or services that have the same pattern of transfer, whether those goods or services are related or unrelated noting that an entity would not be precluded from accounting for two or more distinct goods or services as if they were a single performance obligation if they have the same pattern of transfer. The staff felt that any such practical expedient will evolve in practice.

For arrangements under (c), the staff recommended incorporating as an indicator the ‘pattern of transfer’ notion into the revenue framework for identifying separate performance obligations which would  eliminate the need for the practical expedient in paragraph 30 of the 2011 Revenue Exposure Draft and optional accounting within the revenue model. The staff felt that any unintended consequences would be mitigated by the use of ‘pattern of transfer’ as an indicator rather than a criterion. This would be consistent with the ‘distinct in the context of the contract’ improvement suggested above and as such, the staff recommended adding an indicator to the determination of whether a performance obligation is distinct in the context of the contract.

Both the Boards tentatively agreed with the staff’s recommendation to: a) remove the ‘pattern of transfer’ practical expedient for concurrently delivered goods or services and b) include a ‘pattern of transfer’ indicator for when performance obligations are distinct in the context of the contract for consecutively  delivered goods or services.

Performance obligation satisfied over time

The Boards considered suggested improvements to the criteria proposed in the 2011 Revenue Exposure Draft for determining whether an entity satisfies a performance obligation over time, and as such, can recognise revenue over time. The Board did not consider the feedback received on how an entity should measure its progress towards complete satisfaction of a performance obligation that meets those criteria.  This will be discussed at a future meeting.

The staff noted that in response to Question 1 of the 2011 Revenue Exposure Draft, most respondents supported the addition of the criteria for determining when a performance obligation is satisfied over time and, as such, when revenue could be recognised over time because the criteria provide guidance on how to assess whether the customer obtains control of a service. Most respondents also supported the concept underlying the criteria in paragraph 35(b) as clarified in the Basis for Conclusions. However, the staff noted that the respondents felt that the criteria appear complex and difficult to apply consistently in practice to contracts beyond the construction and production of tangible goods. These respondents felt that the complexity arose from an overlap in the criteria or concepts that require greater explanation and asked the Boards to:

  • clarify the ‘alternative use’ criterion in paragraph 35(b), in relation to the effect that a contractual restriction has on the ability of an entity to readily direct the asset to another customer;
  • clarify the application of the criterion in paragraph 35(b)(ii), which considers whether the customer receives a benefit from the entity’s performance on the basis of a hypothetical assessment of whether another entity would need to substantially re-perform the work completed to date;
  • clarify the relationship between the criterion in paragraph 35(b)(ii) and paragraph 35(b)(i), which considers whether the customer simultaneously receives and consumes the benefits of the entity’s performance as the entity performs; and
  • clarify the ‘right to payment for performance to date’ criterion (in paragraph 35(b)(iii)) and the relevance of a right to payment as a necessary, but not sufficient, condition for recognising revenue over time for some, but not all, types of service contracts.

The staff also noted that a few respondents also questioned the conceptual basis for the criteria in paragraph 35(b) and whether those criteria are consistent with the definition of control.

The staff recommended that the Boards:

  1. Retain the criterion in paragraph 35(a);
    1. The staff noted that the paragraph 35(a) criterion specifies that an entity satisfies a performance obligation over time if the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced. As such, an entity would need to consider the definition of control (paragraph 32) and the indicators of control (paragraph 37) to determine whether the customer controls the asset as it is created or enhanced.
  2. Combine the criteria in paragraphs 35(b)(i) and (b)(ii) into a single criterion that would apply to ‘pure service’ contracts; and;
    1. The staff noted that there is duplication between the criteria in paragraphs 35(b)(i) and (b)(ii) because the criteria were designed to apply to ‘pure service’ contracts, i.e., circumstances where the entity’s performance does not create a recognised asset (because the asset that is created is simultaneously consumed by the customer) and the customer benefits from that performance as the entity performs. The staff commented that the intended distinction between those criteria was for paragraph 35(b)(ii) to specify a basis for objectively determining whether the customer receives the benefit from the service as it is provided by the entity whereas paragraph 35(b)(i) would apply to those circumstances where there is clear evidence that the customer benefits from the service as it is provided rather than upon completion.  However, given the confusion this duplication has caused, the staff recommended simplifying this by combining these criteria into a single criterion.
  3. Link more closely the ‘no alternative use’ criterion in paragraph 35(b) and the ‘right to payment to performance to date’ criterion in paragraph 35(b)(iii).
    1. The staff noted that determining whether a performance obligation is satisfied over time is often based on applying the criteria of ‘no alternative use’ and the ‘right to payment for performance to date’. As such, the staff recommended that linkage could improve an entity’s understanding and application of those criteria.  One of the IASB Board members questioned whether just having the right to payment criterion would be sufficient and the staff clarified that just having a right to payment criterion was insufficient to meet the criteria.  Several IASB and FASB Board members commented that the enhancements were good and more operational.  An IASB Board member expressed concern over the terminology ‘alternative use’ due to potential comprehension and translation difficulties.  The staff agreed to consider using alternative wording or clarifying the meaning of alternative use in the Basis for Conclusions. A FASB Board member commented as to whether there would be consistent application of the alternative use criterion.
    2. The staff recommended clarifying:
      1. right to payment
        1. The payment schedule specified in the contract does not indicate whether an entity has a right to payment for performance to date.
        2. The right to payment should be enforceable and, in assessing the enforceability of that right, an entity should consider the contractual terms as well as any legislation or legal precedent that could override those contractual terms.
      2. a ‘reasonable profit margin’ should represent either:
        1. a reasonable proportion of the expected profit margin under the contract; or
        2. a reasonable return on the entity’s cost of capital for similar contracts if the contract specific margin is higher than the return the entity usually generates from similar contracts; and
        3. the entity should assess whether, for the entire duration of the contract,  the entity would be entitled to an amount that is intended to at least  compensate the entity for performance completed to date.
      3. assessment of alternative use:
        1. there must be a substantive reason for the presence of a contractual restriction in the contract;
        2. a practical limitation might exist if the entity would face a significant economic loss (through either incurring significant costs of rework or selling the asset at a significant loss) if it redirected the asset to another party;
        3. the assessment of alternative use is made at contract inception and the entity considers its ability throughout the product process to readily re-direct the partially completed asset to another customer.

Both Boards tentatively agreed with the staff’s recommendations above, subject to drafting changes.

Licenses

The Boards considered respondents’ feedback to the 2011 Revenue Exposure Draft and possible refinements to the implementation guidance related to licenses and rights to use.  The Boards did not discuss the appropriateness and applicability of the constraint on the cumulative amount of revenue recognised for licenses of intellectual property at this meeting as it will be addressed later in the redeliberations.

The staff noted that while the 2011 Revenue Exposure Draft did not ask a question about the licenses and rights to use proposed implementation guidance, the staff received feedback from several respondents who thought that either the guidance implied that they would be required to recognise revenue at a point in time for all licenses and rights to use or a lack of clarity on what the on-going performance was where it seemed to relate to maintaining or protecting their intellectual property.

The staff recommended that the Boards refine the implementation guidance for contracts that include a promise to transfer a license or right to use to clarify how an entity would identify separate performance obligations in those types of contracts and how an entity would determine when those performance obligations are satisfied because control has transferred to the customer:

  • Clarify that an activity would only represent a promise to the customer when that activity transfers a good or service and that activity is specific to the customer and identifiable within the contract. Such activity may result from an entity’s customary business practice (provided it creates a valid expectation of the customer that the entity will transfer a service).  Several IASB Board members expressed concern over the ‘specific to the customer and identifiable within the contract’ wording as to whether this was intended to be implicit or explicit.
  • Clarify that when an entity provides a service in addition to a license that the entity must consider whether the license and service represent a single performance obligation because together they depict the substance of the contract.
  • Clarify that paragraphs 35 through 37 should be applied to the separate performance obligation in the contract to determine when revenue should be recognised. The staff noted that the Boards should clarify that restrictions on use of the transferred asset during the term of a license are characteristics of the licensed asset and therefore should not affect the evaluation as to when control transfers. Whereas control of the license cannot be transferred before the beginning of the period during which the customer can use and benefit from the licensed intellectual property.  Various members from each of the Boards discussed what their view was on the effect, restrictions on the use of the transferred asset would have on revenue recognition.  One of the FASB Board members was of the view that if there was a perpetual license but there was a restriction on use (e.g., once a week), then revenue should be recognised over time.  Several IASB Board members were of the view that in this situation, revenue should be recognised at a point in time as the selling entity did not have to perform any further obligations and the customer could use and benefit from the licensed intellectual property.

The IASB tentatively agreed with the staff’s recommendations subject to drafting changes.  However, the FASB Chair asked the staff to do more work by taking the illustrative examples in Supplement Agenda Paper 7D and applying the criteria in paragraphs 32-37 of the 2011 Revenue Exposure Draft (as it would have been applied for any other item) to see if the application was operational and whether the results were sensible.  The IASB tentatively agreed with the FASB’s recommendation.

Identifying onerous losses

The staff recommended that the Boards should retain a requirement to identify and measure onerous losses on contracts with customers (i.e., an onerous test) in the revenue proposals.  This would help to meet the objective of convergence as well as to provide useful information.  The staff noted that Question 4 of the 2011 Revenue Exposure Draft sought respondents’ feedback as to whether they agreed with the scope of the onerous test.  Very few respondents agreed with the proposed onerous test and many respondents suggested removing the onerous test from the revenue proposals because they felt the requirements for recognising onerous losses should be included in other standards.

Several IASB Board members mentioned that existing guidance in IAS 37 provided sufficient guidance for determining when to recognise losses arising from contracts with customers.  Other IASB Board members noted that there were difficulties and complexity in applying the onerous test and that costs should not be dealt with in this project and that the onerous test arose primarily in relation to costs associated with the project. Several FASB Board members expressed concern that such an onerous test would introduce complexity into the revenue standard and could lead to different results. The FASB Board members acknowledged that US GAAP did not an have equivalent to IAS 37 but that onerous provision guidance was currently contained in SOP 81-1, Topic 450 and various industry guidance. Several FASB Board members suggested potentially having a spin-off project to consider the onerous test requirement but expressed concern that this may not be completed in time. A FASB Board member was strongly supportive of the proposal as he felt that this was an opportunity to converge.

At the July 2012 meeting, the Boards did not agree with the staff’s recommendation that an onerous test should be included in the revenue standard.  12 IASB Board members did not agree with the staff’s recommendation whereas 3 IASB Board members agreed with the staff’s recommendation.  4 FASB Board members did not agree with the staff’s recommendation whereas 3 FASB Board members agreed with the staff’s recommendation.

In summary, the Boards tentatively decided that they should apply existing guidance (i.e., IAS 37 and US literature respectively) for the time being and that there would be no onerous test included in the final revenue standard.  The Boards tentatively decided not to amend existing onerous models.   One of the IASB Board members to ask the staff to clarify at what unit of account IAS 37 would assess onerous contracts and the staff confirmed that it would be at a contract rather than performance obligation level.

Due to the tentative decision above, the Boards did not discuss or vote on the staff’s suggested modifications to the onerous test. In relation to not-for-profit entities, the FASB tentatively agreed that the original intent was for a narrow contract-based assessment when applying the onerous test and deferred to industry guidance.

Next steps

The Boards will continue redeliberations in September 2012, focussing on determining the transaction price and constraining revenue recognition and on issues relating to combining and modifying contracts.

Related Topics

Correction list for hyphenation

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